The collapse of Silicon Valley Bank (SVB) earlier this month sent shock waves through the global financial system. US regulators had been aware of significant warning signs, but had not dealt with the problem. Trump-era lighter regulatory rules didn’t help.
One of the crucial issues was that the bank had invested much of its assets in longer-term bonds, including US government bonds. While the US government is a sure bet to repay its bonds when they mature, the current value of such bonds fluctuates with the going interest rate, and falls when interest rates rise.
For example, for bonds with a face value of $100 paying 1 per cent a year, if interest rates on new issues rise to 2 per cent, an investor can get the same return by investing less in the new bonds. So the tradable value of the earlier $100 bond falls accordingly. When US bond rates rose to over 3.5 per cent, SVB’s bond holdings plunged in value.
So when SVB faced the prospect of selling their low-interest bonds at short notice, it was exposed to large losses with the potential to wipe out its capital. This precipitated the bank’s collapse. Clearly, SVB’s management hadn’t anticipated this, though they should have. Central Banks had been warning for years of the risk of losses on bonds when interest rates rise.
With an election imminent, it is important party policies and manifestos are objectively costed and tested
Trump’s trade policies would make Mexico far better off at the expense of US workers
Employees love the flexibility of hybrid working but it could prove costly in the long run
In Ireland, we seem to have lost the capacity to build at scale
In the 2013 to 2021 period, inflation was below the target rate of 2 per cent, so central banks bought up large quantities of government debt, driving down longer-term interest rates. This was aimed at raising activity levels, especially investment, so that inflation would return to its planned rate.
Such low rates were always envisaged as a temporary phenomenon, as it was anticipated that, as inflation picked up, interest rates would return to more normal levels. Central banks foresaw that they would make losses on their huge holdings of Government debt – a necessary cost of operating an appropriate monetary policy.
Financial institutions were put on notice of the dangers of relying too heavily on low interest rates continuing indefinitely. Clearly, SVB was not listening
In a 2017 article, Sharon Donnery, the deputy governor of the Irish Central Bank, outlined the likelihood of future central bank losses on these large holdings of government debt when the European Central Bank returned interest rates to more normal levels. She argued: “These potential interest rate losses could be viewed as a comparatively small cost to be incurred in order to achieve the greater economic benefits from the successful implementation of the banks’ policy remit – keeping inflation close to 2 per cent.”
Similar statements had been made by the Dutch and Swedish authorities, among others. Thus financial institutions were put on notice of the dangers of relying too heavily on low interest rates continuing indefinitely. Clearly, SVB was not listening.
Capital reserves
In anticipation of these future losses when interest rates returned to normal, the Central Bank of Ireland has been building up its capital reserves. By end-2021 the bank’s combined reserves to cover losses amounted to over €7 billion. Due to the very favourable deal agreed on the promissory notes, a legacy of the financial crisis, every year since 2013, the Central Bank has sold a tranche of these notes back to the NTMA at a large profit.
Only 80 per cent of these profits were passed on to the Government (which owns the Central Bank), while the bank held 20 per cent as reserves. Since 2016, the bank has also been setting aside additional funds for anticipated losses on bond holdings.
[ Bank regulation ‘strengthened’ but threat of contagion remains, says McGrathOpens in new window ]
[ Banking accountability is easier to demand than deliverOpens in new window ]
When the last promissory notes are sold this year, or early next year, the Central Bank’s decade of big profits will end. It will probably have to start drawing on these large reserves, to cover its losses on its bond holdings as interest rates rise.
The threat of financial chaos that ensued in the UK following the Liz Truss budget last year was linked to the vulnerability of UK pension funds that were caught out by assuming low interest rates were here to stay
Earlier this month the Bundesbank indicated its expected losses in coming years could exceed its €22 billion available capital provisions. While it would not be acceptable for a commercial company to continue to trade when its assets were worth less than its liabilities, central banks are different. The Bundesbank will carry forward its losses to be covered by future profits in more normal times.
While US regulators were asleep and ignored the unwise behaviour of SVB, it would appear that the European regulatory system has been more thorough, at least in relation to the banking system.
Nonetheless, the threat of financial chaos that ensued in the UK following the Liz Truss budget last year was linked to the vulnerability of UK pension funds that were caught out by assuming low interest rates were here to stay. So there remains nervousness about other parts of the financial system that have failed to plan appropriately, and where possible problems may be lurking.
